Definition: Liquidity refers to the availability of cash or cash equivalents to meet short-term operating needs. In other words, liquidity is the amount of liquid assets that are available to pay expenses and debts as they become due. Obviously, the most liquid asset of all is cash.
What Does Liquidity Mean?
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Creditors and investors often use liquidity ratios to gauge how well a business is performing. Since creditors are primarily concerned with a company’s ability to repay its debts, they want to see there is enough cash and equivalents available to meet the current portions of debt.
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Investors, on the other hand, are typically more concerned with the overall health of the business and how it can increase performance in the future. Companies that struggle with liquidity usually have a difficult time growing and increasing performance because short-term funding isn’t available. Poor liquidity is also a sign to investors that the company fails to efficiently generate revenues with its assets to meet its current obligations.
Creditors and investors usually prefer higher liquidity levels, but extremely high levels of liquidity could mean the company isn’t properly investing its resources. For example, if cash represents 90 percent of a business’ assets, investors might speculate why these resources aren’t being used to grow the operations and invest in new capital. Creditors obviously won’t care about this much cash because they just want to make sure there is enough money to pay back the loans.
Some of the most common ratios used to gauge the liquidity of a business is the quick ratio, current ratio, and working capital ratio.
You may have also heard this term used in the format of the balance sheet. For example, the current assets are listed in order of liquidity. This means that the most liquid assetsor assets closest to cash are listed first.
